News analysis

Financial reform

Financial-reform glossary

FINANCIAL reform is coming to America, and policymakers from around the world are mulling changes to international banking standards. The debate over reform has been rancorous and complex, featuring terms that aren't immediately accessible to the non-financial expert. In order to facilitate understanding of the changes that are on the table, we've put together a glossary of financial-reform nomenclature, which we'll be updating throughout the process. In comments, feel free to suggest new terms that you'd like us to define.

Capital requirements (and countercyclicality)

Financial regulators around the world normally insist that banks set aside a certain amount of capital to cover them against possible losses on the loans they grant and securities they invest in. The Basel Committee, an international body where regulators seek to agree on common standards, has set up a framework where a bank's assets (its loans and other investments) are weighted according to their risk. Those risk-weighted assets are then compared to the bank's capital in order to determine if it is adequately capitalised.

Regulators and legislators are looking to tighten capital requirements in the wake of the banking crisis. (They are also considering overlapping limitations, such as leverage ratios, on banks' ability to take risks.) One idea now being discussed is countercyclicality, which would have the banks set aside more capital during good times, when they are suffering few losses on their loans. This would both limit their tendency to take more risks in boom times, and provide a store of extra capital that will cover them when the boom turns to bust. But how much capital should be built up in good times? And how would it be decided when the time has come to start running capital down? Regulators have struggled to agree on all this.And in America, legislators have dodged the issue.

Clearinghouses

Clearinghouses, or central counterparties (CCP), act as the buyer to every seller in a market, and the seller to every buyer. Regulators want more over-the-counter (OTC) derivative contracts to be cleared by clearinghouses. Clearinghouses collect margins on every trade; members put money into a reserve fund as well. Traders only have to worry about the creditworthiness of one entity, with which they can net off their trades. If a big trader goes under the financial system is less likely to go with it. And regulators have a better sense of where exposures are building. To prod derivative markets towards clearing, and ideally trading on exchanges, OTC trades that are not cleared will face a higher capital charge than contracts that are.

But clearing brings some worries of its own. Traders may be more likely to take on risky positions because some of the losses they may generate are ultimately borne by others—the CCP and its other members. While regulators fret that some banks are “too big to fail”, they may be creating another set of institutions of equal systemic importance. If a clearinghouse went down, the government would have little choice but to backstop it.

There is also a risk of creating too many CCPs. Having lots of clearinghouses across geographies and types of derivatives reduces the scope for netting and makes it harder to gain a complete picture of participants' exposures. And some types of instruments are more suited to clearinghouses than others. Clearing credit-default swaps on single-name borrowers is problematic: because a firm is either bankrupt or not, it is difficult for CCPs to demand margins or collateral that vary smoothly with the risk of the loans insured.

Collateralised debt obligation (CDO)

CDOs are structured financial products that use the wizardry of tranching to turn sketchy assets into purportedly safe securities. As with securitisation, bundles of assets (such as mortgage-backed securities) are pooled together. That bundle is then sliced into tranches of different seniority, which have different coupon payments. The junior tranches pay out the most money, but are also the first to have payments reduced when loans default. As more of the assets inside the CDO go bad, tranches of increasing seniority take hits. The top tranches of these things were often given AAA ratings, under the belief that there was no chance enough loans could go bad to leave them short. As it happened, that supposition was dead wrong.

Things get very interesting when parts of CDOs are used to back other CDOs, which are dubbed CDOs Squared.

Counterparty

Any contract involves persons or institutions on either side of the transaction. From the point of view of one party to a transaction or contract, the entity on the other side is the counterparty. While the term is a general one, it is most often used in the context of financial transactions. The risk assumed by either party that the other side (their counterparty) will fail to live up to its contractual obligations is "counterparty risk".

AIG was the counterparty to the banks who bought the credit-default swaps it sold. More generally, a financial institution will be linked to hundreds of counterparties through many different kinds of contracts. As we pointed out in a survey of financial risk, “The Federal Reserve, leading stress tests on American banks last spring, was shocked to find that some of them needed days to calculate their exposure to derivatives counterparties.”

Credit default swap (CDS)

Though not classified as insurance for regulatory purposes, a credit-default swap is really just that. It is a derivative contract in which the so-called buyer of protection pays a stream of premiums to the "counterparty" on the other side of the trade, the seller of protection, in connection with a loan, bond or related index. If the issuer of the debt defaults, the insurance seller must pay the buyer the full face value.

The buyer might be the holder of the bond or, controversially, a speculator with no economic interest—in which case the CDS is "naked". The latter has been compared to taking out insurance on a neighbour's house in the hope of profiting if it burns down. During the crisis, hedge funds were accused of trying to drive down the share prices of banks (and thus drive up the value of CDS protection on their debt that the funds had bought).

The role of CDSs in contributing to the crisis is still a matter of fierce debate. AIG was almost felled by the huge piles of swaps it had written on bundles of mortgage-linked debt, though some blame its shoddy risk-management practices rather than the swaps themselves. Conversely, some investors—most famously, Paulson & Co, a hedge fund—made a killing buying protection on synthetic indices tied to house prices.

The CDS market exploded in the years before the meltdown but has since shrunk substantially, in part because of efforts to net offsetting trades amid regulatory pressure to cut systemic risk. Proposed regulatory reforms on both sides of the Atlantic would shake up the market further, forcing more trades to go through central clearinghouses and to be traded on exchanges.

Derivatives

Derivatives are financial instruments that “derive” their value from other assets. A forward contract commits the user to buying or selling an asset at a specific price on a specific date in the future. A swap is a contract by which two parties exchange the cashflow linked to a liability or an asset. They can be based on pretty much anything—commodities, currencies, shares, bonds, etc—as long as two parties are willing to trade risks and can agree on a price. Derivatives create leverage too. Contracts are sealed with initial payments that are a small fraction of the potential gain or loss.

Many derivatives performed well during the financial crisis. But the role of credit-default swaps, a kind of insurance contract against default, in bringing down AIG, an American insurer, has made derivatives a focal point of reform. AIG guaranteed at least $400 billion-worth of other companies' loans and the American government forked out $180 billion to save it from collapse.

In both Europe and America, policymakers want to ensure that derivatives cannot create obligations that far outstrip the ability of dealers to pay, and that these obligations are more transparent to regulators. In particular, they want more over-the-counter derivatives, which are not traded and are bought directly from dealers, to be centrally cleared and to be traded on exchanges (see derivative clearinghouse). That would force greater standardisation of contracts, help ensure that collateral is being set aside to reflect the risks of each contract, and enable better monitoring of what market participants are up to.

Banks do not like the idea much, since standardisation will eat into their margins. Many companies that use derivatives to hedge their risks are also unhappy since they will be required to put more collateral aside than they do now. A lot of reform debate has centred on whether these end-users can be exempted from new rules.

Leverage

Broadly speaking, leverage is the use of borrowed money to get more bang for your buck. Anyone who takes out a mortgage to buy a house is using leverage: someone who wants to buy a $100,000 apartment but has only $20,000 in cash can take out a mortgage for the remaining $80,000. If the apartment then doubles in value to $200,000, its owner could sell it, repay the mortgage and be left with $120,000—he has thus multiplied his investment by a factor of six. That's nice. But although leverage amplifies gains, it also does the same for losses. If the same apartment halved in value to $50,000, the buyer not only has his original $20,000 wiped out but ends up in the red to the tune of $30,000.

Businesses and banks use leverage a lot, despite the risks, because the rewards can be great. But during the financial crisis some banks were too adventurous and got into trouble. This has led to calls for worldwide restrictions on banks' leverage. The Basel Committee, a body made up of the world's financial regulators, is working on imposing a leverage ratio on banks so that the assets they invest in (the loans they make, the bonds and shares they buy, etc) cannot be more than a certain multiple of their capital.

This is harder than it sounds: banks have many different forms of capital and assets, and there is huge scope to argue about what sorts should be counted in the ratio, and how strict to make the limit. Some reform proposals, including in America, define leverage ratios by comparing a bank's debts, rather than its assets, to its capital. Besides quibbling with the formula, banks may seek ways around any new rules by parking risky assets off their balance-sheets, making it look like they are keeping to the limit. If the ratio is set too low, banks might have difficulty making loans to businesses, and the economic recovery will be hobbled. If it is too high it will do little to restrain risk-taking. Even before the crisis America imposed a leverage ratio on its banks, yet they were not spared.

Liquidity requirements

Banks perform a miracle: they take in short-term deposits, which savers can usually withdraw at will, and transform them into long-term loans that borrowers do not need to repay for years. This is risky. So along with capital requirements that ensure banks have reserves to cover them against losses on their loans and investments, they are also required to demonstrate to their regulators that they have adequate liquidity—ie, that they could get their hands on plenty of cash if, for example, there is a run on the bank. Following the banking crisis, which featured extreme liquidity demands placed on troubled banks like Northern Rock, regulators worldwide are seeking to tighten the rules on how much cash banks must have in store in case of emergency.

The most obvious liquid assets that banks have are their deposits at the central bank and their holdings of high-quality bonds, which at a pinch could be sold or used as collateral to borrow cash. But bonds carry the risk of deteriorating in value, as happened during the financial crisis and, more recently, during the Greek debt crisis. In both cases the European Central Bank loosened its standards for collateral, keeping its lending window open and avoiding a liquidity crisis among the affected banks.

Regulators would like to impose stricter liquidity requirements, but as banks struggle to repair their finances amid growing worries about sovereign debt, their overseers are having to tread carefully.

Macroprudential regulation

Macroprudential regulation is regulatory policy aimed at maintaining the stability of the financial system as a whole (as opposed to microprudential regulation, which focuses on the health of individual firms). We examine some of the elements of potential macroprudential regulation here.

Mortgage-backed security (MBS)

Mortgage-backed securities are bonds whose coupon payments and underlying value depend on the performance of a pool of mortgages. Bonds backed by residential mortgages or commercial mortgages are referred to respectively as RMBS and CMBS. Investors who buy the bonds run the risk that the interest payments and the capital value of the bond may be affected if some of the mortgages in the pool experience late payments or default. To compensate for that risk the bond carries a higher interest rate than high-grade corporate or government bonds; and the principal amount of bonds issued is often smaller than the principal amount of the mortgages in the pool so that mortgage failures, below a prescribed level, will not affect the interest payments on the bonds.

A pool of mortgages may back several different issues (or tranches) of bonds, classified, and rated by a rating agency, according to risk and the amount of loss in the pool that they can bear before being impaired. The riskiest tranche of bonds pays the highest interest and is often called the “equity” tranche.

Mortgage-backed securities became problematic because a) many mortgage brokers and sellers passed on all economic interest in the mortgages to other investors, losing the incentive to exercise quality control; b) ratings given to the classes of bonds issued gave false comfort that the risks involved were well understood. They were not; c) there was a presumption that the bonds would always be tradeable. When the market seized up they were not.

Resolution fund

A resolution fund is a tool that can be used to reduce the risk of financial-firm failure and deflect the cost of such failures onto the financial system, rather than having them fall on taxpayers. Firm failure can be expensive. Depositors must be made whole as, in some cases, must other creditors. When the government takes over a bank, it accepts these costs. For small banks, resolution is handled by the FDIC, which is funded in part by premiums it charges to all banks. For banks that can't easily be wound down by the FDIC, for reasons of size and complexity, resolution expenses must come from somewhere else. It has been proposed that a resolution fund be established and funded by insurance fees or taxes on financial institutions. In the event of a large firm failure, the fund could help absorb the expense involved in winding down the firm.

Securitisation

In days gone by, banks would take care of all aspects of the loan-making process. They would handle the applications, approve and originate the loan, and hold that loan on their books until it was paid off. Securitisation got rid of all that. It is, basically, the process of turning individual, unique loans into tradable securities.

It's all quite simple, really. A loan originator makes loans to customers. It then sells those loans on to other financial institutions, which provide the originator with new capital with which it can make additional loans. The financial institutions then take many such loans, from all over the country, bundle them together, and then cut up the bundle into nice, tradable pieces. So a bundle made up of mortgages would be a mortgage-backed security. The idea behind the practice is that the securities should be less risky since they're made up of lots of individual loans, only a few of which will default (most of the time). And because mortgage debt can be spread through the system, banks no longer have their capital tied up in long-term loans, and they can lend more.

The downsides are that originators, who no longer need to hold the loans, no longer need to worry as much about the creditworthiness of borrowers. And if default rates go up around the country, then risk has not actually been reduced.

Shadow banking system

The shadow banking system refers to a system of lending and borrowing institutions parallel to the traditional banking system but outside of that system's tight regulatory constraints. It is oriented around non-banks which nonetheless behave like banks. They lend long, issuing mortgages and other loans, and borrow short, often by issuing commercial paper. Given this maturity mismatch, shadow banks, like regular banks, are at risk of destabilising runs. Unlike regular banks, however, they lack regulatory oversight, federal deposit insurance, and a regular FDIC procedure for easy winding up in the event of near failure. In September of 2008, this state of affairs nearly brought down the entire financial system. The collapse of Lehman Brothers generated big losses in the commercial-paper market, which proceeded to freeze. Had the government not stepped in to guarantee commercial paper, the sudden lack of funding could have led to a wave of financial-institution collapses.

Systemic risk

Systemic risk is an instability in the financial system that threatens the system as a whole (and with it, the broader economy). Generally speaking, there are three types of systemic risk. There is cascading risk. In this case, the failure of one systemically important institution generates pressure on other firms, which then fail, and so on. There is risk associated with external shocks. If a significant macroeconomic blow affects all financial institutions, the resulting pressure on markets could lead to financial collapse. And there is what you might call “Minsky systemic risk”, named after Hyman Minsky, which is when all firms engage in similarly misguided and unsustainable behaviour. When the party ends, a crash occurs, threatening the financial system. Measures to reduce systemic risk include limits on firm size, requirements for capital and liquidity buffers, various circuit breakers, and macroprudential regulation generally.

“Too big to fail”

“Too big to fail” generally refers to the idea that some institutions are systemically important enough that their failure would be too costly to risk. The direct cost of a bail-out and the accompanying moral hazard are assumed to be less than the cost of allowing a too-big-to-fail firm to go under.

For a firm to be considered too big to fail, sufficient connections must exist between the firm and the rest of the financial system so that the firm's failure could generate cascading difficulties. A firm might be considered too big to fail if it is the counterparty in many trades with many different firms. Or it might be considered too big to fail if its debt is widely held by other vulnerable institutions. Size is a loose correlate for “sufficient connections”.